By James J. Tobin, Esq.
Ernst & Young LLP, New York, NY*
In the world of tax complexity, the Subpart F sales and manufacturing branch rules hold a special place. The U.S. government's most recent contract manufacturing regulations secured the hold the branch rules have on that special place of complexity. The regulations expanded the universe of common business operating structures that will be subjected to a branch rule analysis but left long-standing questions about exactly how that analysis is to be done still unanswered.
Two recent private letter rulings (PLR 200942034 and PLR 200945036), however, have finally unlocked some of the IRS's thinking on both the "effective rate of tax" and the "hypothetical effective rate of tax," which are key concepts in applying the branch rules. The good news for the now-ubiquitous branches is that in applying the fiction of the branch rules the IRS is going to look to the truth of local law for these foreign effective tax rate determinations.
We can take away some very important – and long overdue – basic principles from these new rulings. First off, the tax rate disparity test is to be applied using foreign tax law principles. Second – and a big deal – so-called disregarded payments are to be "regarded," consistent with their treatment under local law. Third, local tax rulings are to be respected (probably). Last – and perhaps most important but unfortunately less clear – it appears that, should the branch rules apply to create a fictional separate corporation, the amount of that corporation's Subpart F income will be computed based on the foreign-law taxable income of the branch.
Without going into detail, the hyper-technical branch rules apply if a controlled foreign corporation (CFC) engages in manufacturing or sales activities outside its country of incorporation through a branch: at stake under the branch rules is whether the CFC will have foreign base company sales income (FBCSI) subject to immediate U.S. tax under Subpart F. Whether there will be FBCSI or not depends on whether conducting such operations through a branch is considered, when viewed through the prism of the branch rules, as having substantially the same effect as if such operations were conducted through a wholly-owned subsidiary of the CFC.
I won't now rehash the history and details of the final, temporary, and proposed contract manufacturing regulations that were issued in December 2008. As I wrote in an earlier commentary, the basic framework of the new branch rules is fairly well thought-out, albeit extraordinarily complicated in its application (see Tobin, "Branching Out: The Subpart F Contract Manufacturing Regulations v2.0," 38 Tax Mgmt. Int'l J. 295 (5/8/09)). This is unfortunate, but perhaps unavoidable, because the reality of modern manufacturing and supply chain arrangements will almost always require an analysis involving the multiple manufacturing branch and multiple sales branch rules of the new regulations.
Most troubling to many tax practitioners (including this one), however, was the government's failure to provide in the new regulations the necessary details on how to compute the effective tax rate of a sales branch or the hypothetical tax rate of the manufacturing branch. Also left unaddressed in the new regulations was how to calculate the amount of the FBCSI that would arise if a taxpayer's branch runs afoul of the rate disparity test and the deemed existence of a second CFC results in FBCSI. It wasn't much consolation to any of us who are expected to be able to apply these rules that the government conceded in the Preamble to the new regulations that it was punting on some of these important questions.
In PLR 200943034, Manufacturing Co in Country 1 sells products to Sales Co in Country 2 which sells those products to customers. Both Manufacturing Co and Sales Co are disregarded subs of Foreign Holdco for U.S. tax purposes. Interest payments are made from Sales Co to Foreign Holdco, which are tax-deductible in Country 2 but which are disregarded for U.S. tax purposes. Dividends are also paid up the chain from Manufacturing Co and are eligible for a 95% dividend exemption in Country 2 when received by Sales Co but are disregarded for U.S. tax purposes. Country 1 tax law also provides for a deduction for interest on net equity.
Under the manufacturing branch rule, the rate of tax paid by Sales Co, as the sales branch of Foreign Holdco, must be compared to a hypothetical rate of tax to which that sales profit would have been subject had the sales income been taxed in Country 1, the country of manufacturing. So the interesting holdings in the ruling on how to do that calculation are the following:
The effective tax rate on the income in Country 2 is determined by taking the actual tax paid by Sales Co and dividing it by the local taxable income of Sales Co as determined under the local tax rules of Country 2. The interest payment made by Sales Co is taken into account for this purpose even though it is a disregarded payment for U.S. purposes. Further, the extent to which the interest deduction is considered to relate to sales income is based on local rules for allocating interest expense. Thus, if no interest expense is allocated to dividend income under Country 2's tax laws (because of the 95% exemption for such income), the full amount of the interest expense would be considered to relate to Sales Co's sales income.
The computation of the hypothetical tax rate on the sales income is determined as if the sales branch – Sales Co – were a separate CFC incorporated in Country 1, the manufacturing location. The ruling makes clear that all available deductions are taken into account in computing the hypothetical tax in the manufacturing location. Therefore, a deduction for the interest on equity is included in the hypothetical tax rate calculation.
Here are some observations:
Relying on the local tax calculation for Sales Co is the right policy answer and it also makes life easy (not that these rules reflect much concern about that). All related-party transactions with other disregarded entities of Sales Co are disregarded for U.S. purposes so if the taxpayer had to disregard them for purposes of the calculations they would have no idea where or how to start. Also, presumably, we can rely on all local law determinations with regard to thin capitalization, transfer pricing, etc. Query, however, what happens if there is a local tax adjustment? Presumably, if it impacts taxable income, the effective tax rate locally would remain the same. But if the adjustment relates to R&D or foreign tax credits, the effective rate could change. This should not be a practical problem in most cases as a local tax audit adjustment most likely would increase the local tax and so could not cause Sales Co to fail the rate disparity test retroactively. But it raises the question: could the rate disparity test be satisfied retroactively and have the effect of retroactively eliminating Subpart F income in the case of Sales Co's local tax being increased in a subsequent local audit?
Including the interest on equity in the hypothetical tax calculation is interesting. It means that one not only needs to focus on how the income of Sales Co would be taxed in Country 1, but also needs to import its balance sheet into an "as if" Country 1 financial statement to figure out the equity and the appropriate interest on the equity deduction. This concept does raise a number of further and unanswered questions:
o Is it the full balance sheet of Sales Co including the non-sales activities, in this case the holding of subsidiary shares?
o If so, presumably one must use Country 1 rules for allocating expenses between dividends and sales income, which may be very different from the expense allocation rules that were actually applied in Country 2, the sales branch location.
o Do we superimpose Country 1 transfer pricing, thin capitalization, bonus depreciation, and other rules in doing the calculation? Interestingly, based on the statutory tax rate and the fact that not too many countries allow a deduction on equity, it appears that Country 1 in the ruling is Brazil, which has a very strange non-OECD set of transfer pricing rules. So overall a full recomputation of the sales branch income in Country 2 under all Country 1 rules would appear necessary.
o How do we compute currency differences?
So there is still some more truth to be sought within this fiction!
The second ruling, PLR 200945036, takes a similar approach with a few noteworthy additional features. In this ruling, there were royalty payments disregarded for U.S. purposes and local APAs in two of the countries involved. The ruling appears to hold that the disregarded royalties were taken into account in both the effective rate calculation and the hypothetical effective rate calculation. The APAs were also taken into account for both purposes. How one would apply the APAs to the Sales Cos as hypothetically incorporated in the country of manufacturing could be interesting.
The next obvious question and perhaps the most important one arises if the rate disparity test is failed and a second CFC is deemed to exist: is the calculation of the amount of FBCSI also based on the local taxable income principles in the sales branch country. In particular, would payments that are deductible under local law but are disregarded for U.S. purposes reduce the Subpart F inclusion and would local tax principles – including transfer pricing rules – be applied to arrive at the Subpart F income amount. This, again, seems to me to be the correct policy answer since Subpart F income is not created with respect to disregarded payments more generally and recomputing all foreign income under U.S. rules – transfer pricing, thin capitalization, etc. – would be both unreasonably burdensome and an unreasonable result. I would read the second ruling to at least imply that this is the result. The ruling refers to "determining" FBCSI under local tax rules and also states that the specific disregarded entity, if it were to fail the rate disparity test, would be treated as the "remainder of the corporation" selling on behalf of the manufacturing branch (that would be treated as a separate corporation) for purposes of determining FBCSI. So I hope this is the result intended, but it would be nice to get that confirmed.
Basically, I'm a somewhat happier guy after digesting both rulings. But perhaps I should keep quiet about that lest I jinx things. And even though I'm a happier guy than I was before, my head still hurts at the thought of applying these rules to the real-world global structures of the companies near and dear to my heart. My big remaining complaint is still that the branch rules overall are way too complex and just plain unnecessary. We've had the branch rules for almost 50 years now and not a single one of our trading partners has found it necessary to copy this page from our playbook, which leaves the United States all alone in this wilderness of complexity. So maybe I'm not really that much happier after all.
This commentary also will appear in the January 2010 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Yoder, 928 T.M., CFCs — Foreign Base Company Income (Other than FPHCI), and in Tax Practice Series, see ¶7130, U.S. Persons' Foreign Income.
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